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CAPITAL BUDGETING CASE: WRITING ASSESSMENT ONE

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Capital Budgeting Case: Writing Assessment One

Kaitlyn Krinock

Seton Hill University

CAPITAL BUDGETING CASE: WRITING ASSESSMENT ONE

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Abstract

This paper will report the findings of financially analyzing two different companies

to form a capital budgeting decision. The companies have been analyzed through

projected income statements, projected cash flows, and finding Net Present Value

and Internal Rate of Revenue from the projected statements. All of the analysis and

calculations will be provided at the end of the paper. Through the analysis, the data

shows that between Corporation A and Corporation B, Corporation B should be the

corporation acquired. Three different peer reviewed sources are used to back up the

data that has been found. Each corporation will be looked at and reported in great

detail, to provide further evidence that backs up the decision that is made to acquire

Corporation B instead of Corporation A.

CAPITAL BUDGETING CASE: WRITING ASSESSMENT ONE

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Capital Budgeting Case- Writing Assessment One

The company was given $250,000 to invest in a company and acquire it. There were

two different options, Co rporation A and Corporation B. In order to choose the best

corporation to acquire, a financial analysis had to be completed. The analysis

included 5 year projected income statements and cash fl ows. From the statements,

Net Present Value and Internal Rate of Return were determined. The decision to

invest in Corporation B comes from the results of the statements, Net Present Value,

and Internal Rate of Return. This paper will report the findings f rom the analysis on

both corporations and evaluate the information that leads to investing in

Corporation B. It will also look into the relationship between Net Present Value and

Internal Rate of Return and also other factors that come into play when faced with a

capital budgeting decision.

Corporation A

The information for Corporation A was provided in order to have the appropriate

details to conduct the analysis. The information for Corporation A is as follows.

Corporation A has beginning revenue of $100,000 a year that increases by 10

percent each year after that. The expenses are $20,000 a year and increases 15

percent each year. The depreciation expenses for the corporation are straight- line at

$5,000 a year, each year. The tax rate for the corporation is 25 percent with a

discount rate of 10 percent. The 5 - year projected income statement was the first

piece that was completed. It shows net income for the next five years. It is calculated

by finding earnings before deprecation and taxes, which is equal to revenue minus

expenses. Depreciation expense is then subtracted from that to find earnings before

CAPITAL BUDGETING CASE: WRITING ASSESSMENT ONE

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taxes. After calculating taxes and subtracting them, net income is what is left over.

The net income for Corporation A increases steadily over the five years. The next

piece is Cash Flow. Cash flow starts by using Earnings Before Depreciation and

Taxes. Depreciation expense is subtracted out, to arrive at Earnings before Taxes.

After calculating taxes and subtracting it out again, depreciation expense is added

back into the earnings. This expense is added back into the cash flow because it is a

noncash expense, so it does not count against the cash flow of the corporation. The

cash flow for Corporation A steadily increases, similar to how the net income does.

After producing the two statements, Net Present Value and Internal Rate of Return

could be found. Net Present Value and Internal Rate of Return are related to each

other; the IRR that is found is the discount rate that would make Net Present Value

equal to zero. The Net Present Value is $20,979.41 and Internal Rate of Return is

13.05 percent. These values would be considered good; if this were the only option

then this would not be a bad investment to make. Net Present Value is positive,

which is the firs t determination that needs to be made. The standard decision for

NPV is that the project should be accepted if NPV is greater than zero and rejected if

NPV is less than 0 (Block, Hirt, & Danielson, 2014). If Net Present Value were

negative, it would be a clear sign that the investment should not be made. Internal

Rate of Return is 13.05 percent; this also verifies that this would be a good

investment. Internal Rate of Return should be a higher yield than t he minimum

threshold, normally the cost of capital for the company (Block, Hirt, & Danielson,

2014). The Internal Rate of Return on this investment is 3.05 percent higher than

CAPITAL BUDGETING CASE: WRITING ASSESSMENT ONE

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the discount rate of the corporation, so there are no signs that this corporation

should not be invested in.

Corporation B

The information to conduct an analysis on this corporation was also provided. The

information is as follows. Revenue for the company for year 1 is $150,000 and the

revenue increases by 8% every year. Expenses for year 1 are $60,000 and increases

10% each year. Depreciation expense is the same ever year at $10,000. The tax rate

is the same as the previous corporation at 25% and the discount rate is 11%. The

income statement s project that the corporation’s income will increase for the next

five years. The cash flow also projects that it will increase each year for the next five

years. Net Present Value of the investment, which was found after completing the

statements, is $40,275.47 and Internal Rate of Return is 16.94%. The information

known about these two numbers show these are acceptable numbers. The NPV is

above zero, which means the project should be accepted and the IRR is 5.94 above

the discount rate of 11%. Analyzing the investment option by these numbers show

that this would be an accepted investment.

Budgeting Decision

The budgeting decision that needs to be made is mutually exclusive. When one

corporation is chosen, the other one will not be (Block, Hirt, & Danielson, 2014). The

capital budgeting decision that needs to be made is between Corporation A and

Corporation B and Corporation B should be invested in. Based off of the statements

and the two different methods of ranking the options, Corporation B ranks as the

best. Looking solely at the statements, net income and cash flow are higher for this

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corporation for each of the five years, so this corporation will make the most money.

Going deeper and looking into the different methods, NPV and IRR both rank this

corporation superior. The Net Present Value difference between the two

corporations is $19,296.06, with Corporation B being the larger number. This shows

that Corporation B is that much greater than zero, which is the determining number

bet ween good and bad investments. The further away from zero, the better the

investment, so NPV also backs the decision to invest in Corporation B. The Internal

Rate of Return differs 3.89% between the two corporations. Corporation A’s IRR is

3.05 above the discount rate, while Corporation B’s IRR is 5.94 above the discount

rate. Since Corporation B’s difference from discount rate is higher, the Internal Rate

of Return calculation also shows the Corporation B is the superior Corporation to

invest in. The previ ous two methods were only two of three methods discussed for

determining the rank of investment proposals. Payback method was the third, which

uses the cash flows to determine how long it will take the investment to get paid

back (Block, Hirt, & Danielson, 2014) . Using this method, the $250,000 required to

invest in these corporations will be paid back in approximately 3.64 years for

Corporation A and 3.31 years for Corporation B. The payback method also supports

the investment in Corporation B.

Limitations

There is one main limitation to analyzing the data for these investments. In the real

world, a large portion of this decision would be dependent on risk. Risk is not a

factor in this capital budgeting decision. The cost of the risk that comes along with

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your investments is a crucial concept for a company and risk can be priced and

defined at different levels because of market imperfections (Froot, 2007).

Another limitation comes from common pract ices. It is not generally correc t to

accept the higher NPV value (Myers, 1974). After calculating NPV, APV should be

found, which is adjusted present value. Adjusted present value is adjusted for the

project’s side effects on other i nvestment and financing options (Myers, 1974).

Although this might be done in the real world, this is not a part of the chapters or

what has been taught in class. Therefore, this is not calculated into the capital

budgeti ng decision.

Conclusions

In conclusion, Corporation B should be the corporation that is invested in and

acquired. The analysis that was completed and the different methods that were used

to rank the two different investment options both support the decision to acquire

Corporation B. There are different limitations that were not factored into the study

and analysis that could potentially affect the decision if they were to be factored in.

Corporation B is the corporation that should be acquired based on Ne t Present

Value and Internal Rate of Return.

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References

Block, S. B., Hirt, G. A., & Danielson, B. R. (2014). Foundations of Financial

Management. New York, NY: McGraw- Hill Education.

Froot, K. A. (2007). Risk Management, Capital Budgeting, and Capital Structure

Policy for Insurers and Reinsurers. The Journal of Risk and Insurance, 74 (2),

273- 299.

Myers, S. C. (1974). Interactions of Corporate Financing and Investment Decisions-

Implications for Capital Budgeting. The Journal of Financ e, 29 (1), 1 - 25.

Exhibits

Exhibit 1. 5- Year Projected Income Statements (Corporation A)

Year

1

2

3

4

5

Revenue

100,000.00

110,000.00

121,000.00

133,100.00

146,410.00

Expenses

20,000.00

23,000.00

26,450.00

30,417.50

34,980.13

Earnings Before Depr & Taxes

80,000.00

87,000.00

94,550.00

102,682.50

111,429.88

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Depreciation Expense

5,000.00

5,000.00

5,000.00

5,000.00

5,000.00

Earning Before Taxes

75,000.00

82,000.00

89,550.00

97,682.50

106,429.88

Taxes

18,750.00

20,500.00

22,387.50

24,420.63

26,607.47

Net Income

$56,250.00 $61,500.00 $67,162.50 $73,261.88 $79,822.41

Exhibit 2. 5- Year Projected Cash Flow (Corporation A)

Year

1

2

3

4

5

Earnings Before Depr & Taxes

80,000.00

87,000.00

94,550.00

102,682.50

111,429.88

Depreciation Expense

5,000.00

5,000.00

5,000.00

5,000.00

5,000.00

Earnings Before Taxes

75,000.00

82,000.00

89,550.00

97,682.50

106,429.88

Taxes

18,750.00

20,500.00

22,387.50

24,420.63

26,607.47

Earnings After Taxes

56,250.00

61,500.00

67,162.50

73,261.88

79,822.41

Depreciation Expense

5,000.00

5,000.00

5,000.00

5,000.00

5,000.00

Cash Flow

$61,250.00

$66,500.00

$72,162.50

$78,261.88

$84,822.41

Exhibit 3. NPV & IRR (Corporation A)

Net Present Value

$20,979.41

Internal Rate of Return

13.05%

Exhibit 4. 5- Year Projected Income Statement (Corporation B)

Year

1

2

3

4

5

Revenues

150,000.00

162,000.00

174,960.00

188,956.80

204,073.

Expenses

60,000.00

66,000.00

72,600.00

79,860.00

87,846.

Earnings Before Depr & Taxes

90,000.00

96,000.00

102,360.00

109,096.80

116,227.

Depreciation Expense

10,000.00

10,000.00

10,000.00

10,000.00

10,000.

Earnings Before Taxes

80,000.00

86,000.00

92,360.00

99,096.80

106,227.

Taxes

20,000.00

21,500.00

23,090.00

24,774.20

26,556.

Net Income

$60,000.00

$64,500.00

$69,270.00

$74,322.60

$79,670.

Exhibit 5. 5- Year Projected Cash Flow (Corporation B)

Year

1

2

3

4

5

Earning Before Depr & Taxes

90,000.00

96,000.00

102,360.00

109,096.80

116,227.

Depreciation Expense

10,000.00

10,000.00

10,000.00

10,000.00

10,000.

Earnings Before Taxes

80,000.00

86,000.00

92,360.00

99,096.80

106,227.

Taxes

20,000.00

21,500.00

23,090.00

24,774.20

26,556.

Earnings After Taxes

60,000.00

64,500.00

69,270.00

74,322.60

79,670.

Depreciation Expense

10,000.00

10,000.00

10,000.00

10,000.00

10,000.

Cash Flow

$70,000.00

$74,500.00

$79,270.00

$84,322.60

$89,670.

CAPITAL BUDGETING CASE: WRITING ASSESSMENT ONE

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Exhibit 6. NPV & IRR (Corporation B)

Net Present Value

$40,251.47

Internal Rate of Return

16.94%